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VAR Analysis
Copyright © 2000-2006
Investment Analytics
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 1
Vector Autoregression
Structural, first order VAR process
yt = b10 – b12zt + γ11yt-1 + γ12zt-1 + εyt
zt = b20 – b21yt + γ21yt-1 + γ22zt-1 + εzt
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 2
VAR in Matrix Form
Restate in matrix form:
⎡ 1 b12 ⎤ ⎡ yt ⎤ ⎡b10 ⎤ ⎡γ 11 γ 12 ⎤ ⎡ yt −1 ⎤ ⎡ε yt ⎤
⎢b ⎥ ⎢ ⎥ =⎢ ⎥+⎢ ⎥ ⎢ ⎥ +⎢ ⎥
⎣ 21 1 ⎦ ⎣ zt ⎦ ⎣b20 ⎦ ⎣γ 21 γ 22 ⎦ ⎣ zt −1 ⎦ ⎣ε zt ⎦
Bxt = Γ0 + Γ1 xt-1 + εt
xt = B-1Γ0 + B-1Γ1 xt-1 + B-1εt
xt = A0 + A1xt-1 + et
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 3
VAR in Standard Form
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 4
VAR Stationarity
Substitution
xt = A0 + A1xt-1 + et
xt = A0 + A1(A0 + A1xt-2 + et-1 ) + et
xt = (I + A1)A0 + A12xt-2 + A1et-1 + et
• I is 2 x 2 identity matrix
After n iterations:
n
xt = ( I + A1 + ... + A ) A0 + ∑ A1i et −i + A1n +1 xt − n −1
1
n
i =0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 5
VAR Stability & Stationarity
Stability condition ∞
A1 n ⌫ 0 as n ⌫ ∞ t
x = µ + ∑ 1 et −i
A i
i =0
⎡ y⎤
µ=⎢ ⎥
⎣z ⎦
y = [a10 (1 − a22 ) + a12 a20 ] / ∆
z = [a20 (1 − a11 ) + a21a10 ] / ∆
∆ = (1 − a11 )(1 − a22 ) − a12 a21
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 6
Stationarity Conditions
Mean is constant: E(xt) = µ
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 7
VAR Model with Lag Operator
yt = a10 + a11 Lyt + a12 Lzt + e1t
zt = a20 + a21 Lyt + a22 Lzt + e2t
⇒ Lzt = L(a20 + a21 Lyt + e2t ) /(1 − a22 L)
a10 (1 − a22 ) + a12 a20 + (1 − a22 L)e1t + a12 e2t −1
⇒ yt =
(1 − a11 L)(1 − a22 L) − a12 a21 L2
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 8
VAR Characteristic Function
Convergence
Roots of (1-a11L) (1-a22L)- a12a21L2 must lie outside
unit circle
Roots can be real or complex
Convergent or divergent
Solutions for {yt}and {zt} will have same roots
So will exhibit similar paths through time
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 9
Stationary VAR Process
Stationary process
a10 = a20 = 0
a11 = a22 = 0.7
a12 = a21 = 0.2
Roots of inverse characteristic fn are 1.11 and 2.0
Outside unit circle, hence stationary
Series have positive cross-correlation
Tend to move together
a12 and a21 are both positive
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 10
Stationary VAR Process
VAR Process
yt = a10 + a11yt-1 + a12zt-1 + e1t
2.0
zt = a20 + a21yt-1 + a22zt-1 + e2t
1.5
1.0
0.5
0.0
0 5 10 15 20
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 11
Non-Stationery VAR Processes
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 12
Multivariate Random Walk
VAR Process
yt = a10 + a11yt-1 + a12zt-1 + e1t
3.0
zt = a20 + a21yt-1 + a22zt-1 + e2t
2.0
1.0
0.0
0 5 10 15 20
-1.0
-2.0
-3.0
-4.0
-5.0
-6.0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 13
Random Walk with Drift
VAR Process
yt = a10 + a11yt-1 + a12zt-1 + e1t
9.0
zt = a20 + a21yt-1 + a22zt-1 + e2t
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
0 5 10 15 20
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 14
Generalized VAR Model
Model form
xt = A0 + A1xt-1 + A2xt-2 + . . . Apxt-p + et
• xt is (n x 1) vector of n VAR process variables
• A0 is (n x 1) vector of intercept terms
• Ai is (n x n) matrix of coefficients
• et is (n x 1) vector of error terms
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 15
Estimation & Identification
Estimation requires n +pn2 terms
Overparameterized
• Some terms undoubtedly redundant
However, goal is to understand relationships
• Not forecasting
Imposing restrictions may waste vital information
Regression analysis
Regressors highly colinear
T-tests not reliable way of reducing model
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 16
Problems with Identification
First Order VAR in standard form
Entails estimating 9 parameters by OLS
• 6 coefficients
• 3 variance covariance estimates for error processes
Primitive system
Contains 10 parameters
Conclusion
Need to restrict one parameter in order to identify
primitive system
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 17
Sim’s Recursive Method
Restrict primitive system
Set coefficient b21 to zero
• {zt} affects {yt} contemporaneously
• {yt} affects {zt} at one-period lag
Model form
yt = b10 – b12zt + γ11yt-1 + γ12zt-1 + εyt
zt = b20 + γ21yt-1 + γ22zt-1 + εzt
Estimation
Estimate Standard Form coefficients using OLS
Solve simultaneously for primitive system coefficients
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 18
Cholesky Decomposition
Factor error variance-covariance matrix
Σ = B-1 A
• Where B-1 and A are triangular matrices
⎡ σ 12 σ 12 ⎤ ⎡1 − b12 ⎤ ⎡ σ y2 0⎤
Σ=⎢ 2⎥
=⎢ ⎥ ⎢ 2⎥
⎣σ 21 σ 2 ⎦ ⎣0 1 ⎦ ⎣− b12σ z σ z ⎦
2
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 19
Vector Moving Average Systems
VAR process
∞ i
⎡ yt ⎤ ⎡ y ⎤ ⎡ a11 ∞ a12 ⎤ ⎡ e1t −i ⎤
xt = µ + ∑ A e i
1 t −i ⎢ z ⎥ = ⎢ z ⎥ + ∑ ⎢a ⎥ ⎢e ⎥
i =0 ⎣ t ⎦ ⎣ ⎦ i =0 ⎣ 21 a22 ⎦ ⎣ 2 t −i ⎦
⎡ e1t ⎤ 1 ⎡ 1 − b12 ⎤ ⎡ε yt ⎤
⎢e ⎥ = (1 − b b ) ⎢− b 1 ⎥⎦ ⎢⎣ε zt ⎥⎦
⎣ 2t ⎦ 12 21 ⎣ 12
− b12 ⎤ ⎡ε yt ⎤
i
⎡ yt ⎤ ⎡ y ⎤ 1 ⎡ a11 ∞ a12 ⎤ ⎡ 1
⎢ z ⎥ = ⎢ z ⎥ + (1 − b b ) ∑ ⎢a ⎥ ⎢− b ⎥ ⎢
1 ⎦ ⎣ε zt ⎦ ⎥
⎣ t⎦ ⎣ ⎦ 12 21 i = 0 ⎣ 21 a22 ⎦ ⎣ 12
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 20
Impact Multipliers
Impact multipliers
⎡ A1i ⎤⎡ 1 − b12 ⎤
φi = ⎢ ⎥ ⎢− b ⎥
⎣ (1 − b12b21 ) ⎦ ⎣ 12 1 ⎦
⎢ z ⎥ = ⎢ z ⎥ + ∑ ⎢φ (i ) φ (i )⎥ ⎢ε ⎥
⎣ t ⎦ ⎣ ⎦ i =0 ⎣ 21 22 ⎦ ⎣ zt −i ⎦
∞
xt = µ + ∑ φiε t −i
i =0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 21
Impulse Response Functions
Measure cumulative effect of shocks
Example:
• φ12(0) measures instantaneous impact of change in εzt on yt
Long run multiplier n
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 22
Cointegration
Engle & Granger 1987
Non-stationary, integrated variables
Linear combinations may be stationary
Known as cointegrated
System of economic variables in long-run equilibrium
β1y1t + β2y2t + . . . + βnynt = 0
Equilibrium error process
et = βyt
et are random deviations from equilibrium
Should be a stationary process
Components y1t, y2t , . . . are said to be cointegrated
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 23
Cointegration – Formal Definition
Components of vector yt are said to be cointegrated of
order (d, b) if
All components of are integrated of order d
∆dyt is stationary
There exists vector β = (β1, β2, . . . βν) s/t
β1y1t + β2y2t + . . . + βnynt is integrated of order (d-b)
• b>0
Vector β is called cointegrating vector
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 24
Examples of Cointegrated Processes
Forward rates
Expectations theory Et[st+1] = ft
Error process εt+1 = st+1 – ft
• {εt+1} must be a stationary process
– Otherwise arbitrage
• Even though {} and {ft} are nonstationary I(1) processes
Currencies – PPP
Difference in real exchange rates must be stationary
Econometric models in general
e.g. Money demand as linear function of prices, real income
and interest rate
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 25
Notes on Cointegration
Linearity
Possible that non-linear relationship exists
Cointegrating vector not unique: λβ
• λ constant >0
• Usually normalize β so coefficients sum to 1
All variables must be integrated of same order
If y1t is I(d1) and y2t is I(d2) then any linear combination is I(d2)
Usually “cointegration” means variables are CI(1,1)
Residual error process is I(0)
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 26
Cointegrating Rank
Refers to # of linearly independent
cointegrating vectors
If yt has n components
At most n-1 linearly independent cointegrating
vectors
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 27
Example: CI(1,1,) System
Two random walk processes
yt = µyt + εyt
zt = µzt + εzt
µit is random walk representing trend
εit is stationary error process
• May not be white noise
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 28
Example: CI(1,1) System
CI(1,1) Process
yt = µ t + ε yt
10.0 z t = µ t + ε yt
µ t = µ t-1 + ε t
8.0
6.0
4.0
2.0
0.0
0 5 10 15 20
-2.0
-4.0
-6.0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 29
Error Process is Stationary
Error Process {yt - z t}
2.0
1.5
1.0
0.5
0.0
1 6 11 16
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 30
Scatter Plot of System Variables
Scatter Plot of System Variables
1.0
0.5
0.0
-4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0
Z(t)
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
Y(t)
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 31
Stationarity Condition for CI(1,1)
If yt and zt are CI(1,1) then
β1yt + β2zt is stationary
• For some non-zero values of β1 and β2
Hence β1(µyt + εyt ) + β2(µzt + εzt ) is stationary
Implies β1µyt + β2µzt = 0
Two processes must have same stochastic trend if
they are CI(1,1) (up to scalar)
µyt = -β2µzt / β1
yt – zt = εyt – εzt is stationary
Cointegrating vector is β = (1, -1)
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 32
Error Correction Models
Idea:
Short term dynamics are influenced by
deviation from long term equilibrium
Example
Interest rate term structure
• Mean reversion property
Model implies system variables are
cointegrated
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 33
Simple Term Structure Model
Idea: short rates and long rates converge
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 34
Granger Representation Theorem
For any set of I(1) variables
Error correction and cointegration
representations are equivalent
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 35
VAR, Cointegration & Error Correction
⎡(1 − a11 L − a12 L ⎤ ⎡ yt ⎤ ⎡ε yt ⎤
⎢ − a L (1 − a L ⎥ ⎢ z ⎥ = ⎢ε ⎥
⎣ 21 22 ⎦ ⎣ t ⎦ ⎣ zt ⎦
(1 − a22 L)ε yt + a12 Lε zt
yt =
(1 − a11 L)(1 − a22 L) − a12 a21 L2
(1 − a11 L)ε zt + a21 Lε zt
zt =
(1 − a11 L)(1 − a22 L) − a12 a21 L2
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 37
Conditions for CI(1,1)
One λ1 = 1, | λ2| < 1
(1 − a22 L)ε yt + a12 Lε zt
yt =
(1 − L)(1 − λ2 L)
Hence
(1 − a22 L)ε yt + a12 Lε zt
(1 − L) yt = ∆yt =
(1 − λ2 L)
Stationary if | λ2| < 1
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 38
From Cointegration to Error Correction
Restate VAR as error correction model
∆yt = α y ( yt −1 − βzt −1 ) + ε yt
∆zt = α z ( yt −1 − βzt −1 ) + ε zt
α y = −a12 a21 /(1 − a22 )
β = (1 − a22 ) / a21
α z = a21
CI(1,1) conditions ensure that this is a valid EC model
β <> 0
At least one speed of adjustment parameters <> 0
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 39
Vector Autoregression (VAR) and
Granger Causality
Let {Xt} and {Yt} be stationary series such that
Xt = A(L) Xt + B(L) Yt + εx,t
Yt = C(L) Xt + D(L) Yt + εY,t
• εY,t and εx,t are separate white noise processes
• A, B, C, D are polynomials in the lag operator
Y strictly Granger causes X if
Some of the coefficients of B are non-zero
X strictly Granger causes Y if
Some of the coefficients of C are non-zero
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 40
Granger Causality in Financial Markets
Example: cash vs futures
k =+ n
Rc ,t = α + ∑
k =− n
β k R f ,t − k + β z zt −1 + ε t
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 41
Results of Research Into Causality
Fleming (1996)
S&P500 index futures lead cash by just over 5 mins
Chung & Ng (1990)
• S&P 500 futures lead cash by at least 15 mins.
Grunbichler (1994)
DAX index futures lead cash by 15-20 mins
Abhyankar (1998)
FTSE 100 index futures lead cash by 5-15 mins
Park & Switzer (1997)
90-day t-bill futures lead forward rates
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 42
Example: Interest Rates
Let R(k, t) be the k-period rate at time t
R(k, t) = (1/k)[EtR(1,t) + EtR(1,t+1) + . . .
+EtR(1,t+k-1) + L(k,t)
L(k,t) is the risk/liquidity premium
• Average expected return for investing for k periods
= expected return for k successive 1-period
investments
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 43
Interest Rates
Reformulate equation as interest rate spread:
1 ⎡ k −1 i ⎤
R (k , t ) − R (1, t ) = ⎢∑∑ Et {∆R(1, t + j )}⎥ + L(k , t )
k ⎣ i =1 j =1 ⎦
Stationarity
R(k,t) is I(1) and L(k,t) is stationary
Hence R(k,t)-R(1,t) is stationary
Cointegration
From above, expect to find (n-1) cointegrating relationships
between n interest rates of different maturities
R(k,t)=R(1,t)+ak k = 2, . . . , n
• ak positive and increasing with maturity
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 44
UK Interest Rate Model
Pesaran& Pesaran 1994
VAR analysis on monthly LIBOR
1m, 3m, 6m, 12m LIBOR rates
• Endogenous I(1) variables
EEF = effective exchange rate
• Percentage change lag 1
Dummy variables for 84(8), 85(2), 92(10)
• Outliers (eg. exit ERM)
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 45
UK LIBOR
UK LIBOR
20.0
18.0
1M
16.0 3M
14.0 6M
12M
12.0
10.0
8.0
6.0
4.0
2.0
0.0
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
19 1
1
M
M
M
M
80
81
88
89
90
91
82
83
84
85
86
87
92
93
94
19
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 46
Modeling Procedure
Step 1 Unrestricted VAR
Test to find appropriate order of VAR
Step 2 Estimate Cointegrating VAR
Find cointegrating vectors
Step 3
Estimate Impulse-Response functions
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 47
Step 1 – Estimating VAR Order
List of variables included in the unrestricted VAR:
R1 R3 R6 R12
List of deterministic and/or exogenous variables:
INPT DLEER(-1) D84M8 D85M2 D92M10
*******************************************************************************
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 48
STEP 2 – Cointegrating Vectors
Cointegration with restricted intercepts and no trends in the VAR
Cointegration LR Test Based on Maximal Eigenvalue of the Stochastic Matrix
*******************************************************************************
175 observations from 1980M3 to 1994M9 . Order of VAR = 2.
List of variables included in the cointegrating vector: Conclude
R1 R3 R6 R12 Intercept there are 3
List of I(0) variables included in the VAR: cointegrating
DLEER(-1) D84M8 D85M2 D92M10 vectors
List of eigenvalues in descending order:
.39641 .31188 .11064 .022479 .0000
*******************************************************************************
Null Alternative Statistic 95% Critical Value 90% Critical Value
r=0 r=1 88.3497 28.2700 25.8000
r<= 1 r=2 65.4148 22.0400 19.8600
r<= 2 r=3 20.5200 15.8700 13.8100
r<= 3 r=4 3.9787 9.1600 7.5300
*******************************************************************************
Use the above table to determine r (the number of cointegrating vectors).
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 49
Step 3 – Cointegrating Vectors
ML estimates subject to exactly identifying restriction(s)
Estimates of Restricted Cointegrating Relations (SE's in Brackets)
Converged after 2 iterations
Cointegration with restricted intercepts and no trends in the VAR
*******************************************************************************
Vector 1 Vector 2 Vector 3
R1 .98321 .93871 .86499
( .011437) ( .028626) ( .050086)
R3 -1.0000 0.00 0.00
( *NONE*) ( *NONE*) ( *NONE*)
R6 0.00 -1.0000 0.00
( *NONE*) ( *NONE*) ( *NONE*)
R12 0.00 0.00 -1.0000
( *NONE*) ( *NONE*) ( *NONE*)
Intercept .29809 .85018 1.7407
( .13362) ( .33287) ( .58088)
*******************************************************************************
LL subject to exactly identifying restrictions= 67.8656
*******************************************************************************
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 50
Impulse Response Function
How shocks in R1 affect Term Structure
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 51
Summary
VAR models
Extensions of simple univariate analysis
Emphasis on understanding relationships
Cointegration
Important idea in finance: linear combinations of non-
stationary processes may be stationary
Error Correction models
Model return to long term equilibrium
Equivalence to cointegrated systems
Copyright © 2000 – 2006 Investment Analytics Forecasting Financial Markets – VAR Analysis Slide: 52